Is it Time to Regulate ESG Scores and Ratings?

End-users are seeking more transparency around cost and methodology to improve comparability.

With an ever-increasing focus by asset managers and institutional investors on incorporating ESG factors into investment decisions, demand for ESG scores and ratings has seen a complementary surge.

Assessing ESG performance across multiple criteria is challenging, as it can be disparate and difficult to compare. Supporting due diligence with quantitative data, ESG ratings and other tools have emerged to help asset managers and investors evaluate and compare current investee companies and future investment prospects.

These data services have been a helpful proxy for investors with limited time and resources when looking to avoid ESG risks across extensive portfolios. But now their future is in question.

In Europe, there are tougher regulatory expectations for asset managers to take into account, such as the European Commission’s (EC) Sustainable Finance Disclosure Regulation (SFDR), Non-Financial Reporting Directive (NFRD) and the EU Taxonomy. Collectively, these changes are holding asset managers to a higher standard when offering sustainable investment products. For investors, clearer guidelines make it easier for them to assess whether managers and investee companies are aligning with new guidelines for sustainability disclosures, ESG product definitions and ESG-tilted funds.

As a result, pressure is rising for higher standards to be enforced on third-party vendors, through regulations that call for more transparency on ESG scores and ratings.

“It’s clear that regulating third-party ESG data issuers and providers is key to improving market access to high quality data. It remains one of the missing pieces of the EU Sustainable Finance Action Plan to build a better, more secure sustainability reporting framework,” says Stéphane Janin, Head of Global Regulatory Development at AXA Investment Managers.

In a joint paper outlining possible third-party data vendor standards, the French and Dutch regulators for financial markets – the Autorité Des Marchés Financiers (AMF) and Autoriteit Financiële Markten (AFM) – predicted that the ESG data and services market could reach a value of over US$5 billion by 2025. While the industry remains largely unregulated, the regulators noted that the influence of the industry is expected to continue to grow.

The AMF and AFM have proposed a regulatory framework that would require greater transparency on methodologies and costs by sustainability-related service providers (SSPs). This would include specific requirements on internal controls and governance to better ensure the reliability and quality of the ratings and services provided. The regulators propose supervision by the European Securities and Markets Authority (ESMA), adding “management of conflicts of interest should be the cornerstone of this regulation”.

Last month, ESMA wrote to the EC further backing industry calls for regulations to be introduced for European ESG ratings agencies and other third-party data vendors.

Due to a current lack of regulation, observers assert third-party vendors are not providing enough transparency around costs and methodologies, and ESG scores remain inconsistent across vendors, making comparability all the more difficult.

“ESG ratings vary strongly depending on the provider chosen, which can occur for a number of reasons, such as having different frameworks, measures, key indicators and metrics, data use, qualitative judgement and weighting of subcategories,” the Organisation for Economic Co-operation and Development (OECD) said in its 2020 ‘ESG Investing: Practices, Progress and Challenges’ report.

Improving transparency around costs…

According to Dan Mistler, Head of ESG Services at ACA Compliance Group, one of the main issues for asset managers procuring ESG ratings and scores is that one set of scores from one third-party vendor usually isn’t enough. “Users often have to purchase multiple sets of data from different third parties,” he says, adding that one set of ratings doesn’t always measure all the aspects of a company an asset manager may want to see.

The costs quickly stack up, leaving asset managers and investors asking for more transparency and justifications around pricing.

“The current lack of transparency around cost is a key issue, even when this data and research is based on publicly available information,” agrees Giorgio Botta, Regulatory Policy Advisor for Sustainable Finance and Stewardship at the European Fund and Asset Management Association (EFAMA).

EFAMA, which has publicly expressed its support for the French and Dutch regulators’ proposals, had previously raised its own concerns around the rising costs of ESG scores and ratings. The association warned that rising costs are putting pressure on smaller firms which have “less resources and bargaining power”, as well as costing the end-investors.

“There’s no justification as to what is building the costs behind scores provided by third parties. There’s no price list,” Botta says. “We do think there’s a big gap between existing regulations for asset managers and third-party vendors, and there’s therefore a strong need for regulation.”

The AMF and AFM further noted that third-party ESG data providers needed to ensure their fees “are not discriminatory”.

“Fees charged for rating services shall not depend on the level of the ESG ratings issued by the providers or on any other result or outcome of the work performed,” the regulators said.

… and methodologies

The need for transparency also includes the process behind the collation and analysis of any raw data that informs the final score or rating from third-party vendors, say the French and Dutch regulators.

“The lack of transparency concerning SSPs’ methodologies, as well as the role of estimates, makes it difficult to correctly appreciate what the ratings reflect. This can lead to a misallocation of investments or even greenwashing, jeopardising the EC’s objectives on sustainable finance,” they said.

Janin suggests users need to understand more about the underlying processes used to generate scores. “To justify our investment decisions, in order to comply with our own duties, we need reliable data,” he says.

Access to the methodologies developed by different SSPs better enables asset managers to “combine third-party scores with their own methodology models in order to incorporate the information into any investment strategies and products they may have,” adds Botta.

Crucially, asset managers are held accountable for the information they provide by regulation while third-party vendors are not liable, Botta continues. This means the asset manager needs to understand how the ratings have been decided and presented before disclosing. Having more visibility of third-party methodologies will ensure there are better levels of compliance from asset managers, he says.

The AMF and AFM have suggested increased transparency should involve information on the main source of raw data used, the markets processes in place for data collation and how the absence of any reported data is managed.

As well as this, the regulators noted that any potential conflicts of interest should be highlighted. “SSPs can assume different roles, such as consultant, data provider or rating agency, and represent diverse interests from issuers to investors. It is therefore important that potential conflicts of interest are managed and averted, ensuring an appropriate level of market transparency.”

Different ESG scores; same companies

With differing methodologies comes different ESG scores, even when using the same raw data from issuers, which makes comparability more challenging.

“The different methodologies used to translate raw data into a more sophisticated rating suffer some level of criticism because of the wide variance in the results,” the OECD said. “The ESG score differences […] may relate to different frameworks, measures, key indicators and metrics, data use, qualitative judgement, weighting of subcategories and re-weighting of scores to ensure ‘best in class’ in industries.”

Differences between ratings makes it more difficult for investors to manage the material ESG risks within their investment portfolios. Furthermore, it becomes difficult to identify which ESG scores are the most accurate for a certain company.

“It’s widely understood that different rating agencies produce different scores,” Botta says. “It would be manageable if their methodologies were better explained, so asset managers could understand the context.”

Janin contends there is a “wider discrepancy of results” among ESG ratings services compared to more traditional credit rating providers. This adds “some degree of uncertainty as to the reliability of some ESG rating data, which can put asset managers at legal risk when attempting to justify their own decisions”.

Many asset managers use external ESG scores as inputs into internal models, rather than relying solely on a third party. But the ‘black-box’ nature of many services and the deviations in their outputs leaves room for uncertainty.

Introducing regulations that would enforce a level of transparency around both methodologies and costing would help end-users to more easily identify why ESG scores for the same companies are different depending on the vendor, Janin adds.

“While different methodologies, judgements and data are welcome to offer investors a choice of approaches and outcomes, large differences in ESG ratings across providers may reduce the meaning of ESG portfolios that weight better-rated firms more highly,” the OECD said.

Regulation vs innovation

While many would welcome regulation of ESG ratings and scores, some experts fear a squeeze on innovation.

“The economic model of many small providers remains fragile and it is important to maintain a diversified offering,” AMF and AFM noted in their joint paper, adding that a “proportionality regime” should be inserted into any future regulation.

Consolidation means the market includes both Davids and Goliaths. Last year, S&P Global noted that rating agencies and index providers are increasingly “buying up smaller firms that provide ESG ratings and research”, bringing ratings and scores into regulated organisations. For example, in April 2020 Morningstar acquired a 60% stake in Sustainalytics.

“You have to have balance between the regulation and giving third-party vendors the ability to incorporate their own individual proprietary methodology in order to differentiate it from its competitors,” Mistler says.

Having differing ESG scores and ratings for the same companies is no bad thing, he notes, so long as the end-user is able to understand how they are derived. Third-party vendors need the space to build their own brand value as they compete with others in the market, including through unique methodologies. While it’s important to support rigorous due diligence, regulators should be careful to “not limit a market that remains very innovative and is constantly evolving”.

“Regulation should be used to help clearly identify the raw data provided directly by the companies themselves, and how the vendors are then interpreting it,” he says.

Raza Naeem, Counsel at Linklaters, says regulatory measures could have a more extreme impact on smaller vendors.

“It would make more sense to have some kind of proportionate regulatory framework in place to ensure the smaller, independent research houses are not squeezed out,” Naeem says.

“Currently, independent research houses can give out their research – research isn’t regulated by itself. Introducing regulatory measures would therefore be a big change for them.”

On the other hand, increased regulation would benefit smaller asset management players, guaranteeing the baseline quality of third-party data, rather than having to invest in establishing an internal research capacity.

“It shouldn’t just be the asset managers’ responsibility to validate the data, I think it’s very much the duty of the data provider and issuer,” Naeem tells ESG Investor.

Julia Vergauwen, ESG Funds Lawyer at Linklaters, highlights the possibility of bigger asset managers instead deciding to generate ratings and scores in-house, a development which may be all the more likely without regulations monitoring third-party vendors.

Furthermore, with greater pressure for ESG product and reporting transparency, asset managers may take control of their data sourcing and invest in establishing their own research arm, cutting out third-party vendors entirely, she adds.

“At this stage, the big issue for the asset management industry is getting data directly from the investee companies and ESG data providers are in a position where they can ease that burden. At the same time, this does expose asset managers to the risk of over-reliance on ESG data providers’ methodologies when making their investment decisions around it,” Vergauwen says.

“To avoid such over-reliance, the regulator must regulate corporate ESG reporting, which will give asset managers access to first hand good quality information.”

Support for regulatory changes

As outlined in the OECD report, ESG scoring and rating methodologies are becoming more robust. There is, for example, more back-testing of scores against performance to better determine the accuracy of the ratings, “scoring remains in a state of transition”. Introducing a more clearly defined regulatory framework will greatly benefit the implementation of ESG data in the investment industry, experts argue.

While the French and Dutch regulators are very much focused on the European approach to regulating ESG rating and scores from third-party vendors, the rest of the world is likely to follow when action is taken.

The AMF and AFM noted that entrusting ESMA as the overarching supervisor of any such regulatory framework – as opposed to a national authority – this will better allow providers and clients to “operate on a cross-border basis”, in Europe at least.

As a global asset manager, Janin hopes that any regulations introduced will allow for a more “global harmonisation” in due course.

“Regulation of ESG data needs to facilitate a convergence in regulation for issuers at a global level,” he says. “Having some kind of global harmonisation would make it easier to compare data from issuers across the globe by helping us ascertain data is more consistent in terms of transparency and methodology.”

Nonetheless, while regulating ESG scores and ratings will improve comparability, accuracy and relevancy of ESG-aligned investment processes, Mistler says the task of interpreting and contextualising the data remains an important priority for asset managers and investors.

“Data in isolation isn’t enough,” he says. “It’s important to contextualise through independent, granular and organic research to better understand the building capacity of the data according to the individual’s needs.”

In a future article, ESG Investor will explore the future evolution of ESG-related data services, exploring drivers of supply and demand.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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